Enjoy Loonie Power: Part II

by: Larry MacDonald

With the Canadian dollar rocketing upward by 25% against the U.S. dollar since March, the benefits of foreign diversification are to be had with less gnashing of teeth. That is, if a long-term Canadian investor were to begin diversifying outside the country now, their U.S. assets will likely spend more time showing currency gains over the next few years; a short-term investor (horizon of up to three to five years), will more likely be in a position to take currency profits.

That’s because of the historical tendency of the U.S.-Canadian dollar exchange rate, which is to move between $0.70 (U.S.) and $1.05 (U.S.). When an investor buys near, or at, the historical upper boundary, the loonie will in all probability be trending back down sometime within the next few years. The flip side of this move, of course, is an upward trend in the U.S. dollar, i.e. U.S. assets held by Canadians will be basking in the glow of currency gains.

In addition to this historical tendency, there are several other factors to suggest putting more eggs in the U.S. basket as the loonie moves closer to its upper boundary:

• The loonie is presently overvalued by 20% according to the purchasing power parity doctrine

• Loonie strength has been fuelled by signs of a greater recovery in the Canadian economy but the soaring loonie is offsetting policy stimulus while the falling U.S. dollar is adding to U.S. stimulus — so relative growth rates should shift over time in favor of the U.S. and support the its currency

• The Bank of Canada hasn’t intervened in foreign exchange markets since 1998 but it and the federal government have been jawboning about the hazards of a high loonie for months, so the hands off policy on currency intervention could be reversed at some point, especially if the loonie surges past parity

• Unlike other past run-ups in the loonie, this one is occurring with a deficit in the trade balance and while inflation is diving below the Bank of Canada’s target rate, further suggesting that currency intervention could be applied to stop the loonie’s rise

• Intervention by the Bank of Canada can be carried out almost without limit since there are no operational constraints on printing domestic currency and buying up U.S. currency and government bonds (China has been doing this for years); this would definitely be a possibility should the economy begin to wilt under the weight of the loonie’s rise.